How Protected is Your Family Business from Creditors?

This article first appeared in the Spring 2017 issue of Massachusetts Family Banker magazine.

Alexander Bove

Many family business owners become complacent about creditor exposure because they believe their corporate or limited liability company structure will protect the business. The fact is that if it is a corporation and you or anyone else owns shares in their own name, jointly with another, or even in a revocable trust, the answer is, it’s not protected. If it is held in a limited liability company (LLC), formed in Massachusetts or one of several other states with similar LLC law, the answer is, it’s not protected. Unfortunately, most business owners are far less familiar with the principals of asset protection than they are with how to build and maintain a successful business.

It is common knowledge, for example, that running a business in corporate form can protect the shareholders from liabilities of the business itself, but few stop to realize that the liability of a shareholder, especially a majority shareholder, can be satisfied by the assets held by the corporation. That is, a judgement creditor can reach the shares owned by a debtor and could exercise ownership of the shares.

If the shares represent a controlling interest in the business, the creditor can literally “take over” the business and run it (profitably or into the ground), sell it, or liquidate it. And don’t think that holding these shares in an estate planning trust helps. Such trusts are typically revocable by the “owner” and offer no protection whatsoever.

Many think an LLC will avoid this exposure, since the LLC laws protect the business from the debts of a member, and a judgement creditor may not become a member or vote the debtor’s interest, or look at the LLC books. Therefore, the LLC does offer somewhat of an obstacle, at least slowing the creditor down, but by no means does it offer true protection. The immediate protection it offers is a wall between the creditor and the assets held within the LLC. Unlike using control of corporate stock to reach the assets held in a corporation, a judgement creditor of a member of an LLC has no right to reach the assets inside the LLC.

But the “wall” does not make the judgement on the debt go away. Despite the wall, a determined creditor could conceivably acquire the debtor/member’s interest in the LLC, depending on the circumstances and the governing state law. The first remedy of a creditor of a member of an LLC is to obtain a “charging order” against the LLC interest. This is a court order directing that any payments that are to be made to the debtor/member must be paid instead to the creditor until judgement is satisfied.

In some states, including Massachusetts, if it looks like the LLC is stalling or contriving to circumvent the court’s order, the court can order a foreclosure (forced public sale) of the debtor/member’s share, causing the interest to be lost entirely (unless, of course, the LLC pays the creditor). Thus, even under the “better” of the two possible outcomes the debtor/member’s share of the profits is cut off until the debt is paid. This is not asset protection. Under the “worse” of the two outcomes, the creditor could purchase the debtor/member’s interest at the foreclosure sale and just sit with the interest until distributions are made or until the LLC is sold.

Asset protection begins with a careful review of the family’s interests, circumstances and objectives, with a view towards protecting assets from creditors without giving up benefits or control. And it must be noted that any such plan will require a considerable move from the status quo and the introduction of new documents into the family plan. It will also typically require re-titling of major assets. Once this small hurdle is overcome, the business owner would see that there are ways to retain control over a company without exposing ownership of the company to creditors; and there are ways of protecting children’s and grandchildren’s company interests and other assets from their creditors; and there are ways of passing the baton without passing the exposure.

To accomplish such objectives requires not only a careful and expert structuring of the underlying entities, having in mind the family’s immediate, intermediate and long-term objectives, but also recognition of the need for, and ways to develop, flexibility. Even the best current plan can be subsequently handicapped or rendered vulnerable to creditors by unforeseen changes in the family, such as divorce or disability, a change in the law or a change in the nature of a major asset. Flexibility must be built into the plan, as well as provisions for a periodic monitoring of the plan to consider ongoing family developments, objectives and changes of any sort that might affect the plan.

Alexander A. Bove Jr. is a partner in the Boston office of Bove & Langa, an estate planning and asset protection firm. He is adjunct professor of law, emeritus, of Boston University Law School Graduate Tax Program. He may be reached at bove@bovelanga.com.